Question

Essay question corporate finance:

What changes when a company is financed with both equity and debt (=”financial leverage”)? Explain in detail.

Answer 1

A Company's capital structure consist of Equity, Debt . Capital structure is the mix of long term debt on which interest and principle payments are made, and equity , in the form of common and preferred stock, which the firm uses to finance operations. The capital structure affects both the risk and returns of the firm and is directly related to Leverage. Leverage is also sometimes refered to as gearing.

There are 2 types of leverage

Financial Leverage and Operating Leverage.

Financial leverage is the use of debt ( fixed cost funds) to increase returns to owners (stockholders). Debt that is loo low may result in a company not being able to take full advantage of opportunities. Debt that is too high may affect the company's ability to weather difficult economic times and to pay its obligations as debt or interest payments come due.There is no standard guideline or optimal leverage number,it varies by industry and firm. Firms have a mix of debt and equity financing. debt holders , including financial institutions and corporate bond investors are often but not always promised a return based on the stated interest rate for the debt. There are costs associated with issuing debt and equity( debt is usually cheaper but the cost will increase as the firms's ratio of debt to equity increases). Most companies maintain a balance of debt and equity based on the cost of capital for each and the level of risk they wish to maintain.

Taking about the operating leverage it is the existence of fixed operating cost. Because these costs are fixed the higher the percentage of operating leverage the greater the effect changes in sales revenues have on operating income.

The formula's for calculating the degree of operating and financial leverage is mentioned below ( not asked in the question but its an add on info)

Degree of financial Leverage = % change in Net income/ % change in Earnings before interest and taxes

or

DFL = EBIT/ Earnings before taxes

Degree of operating Leverage = % change in EBIT/ % change in Sales

or

DOL= contribution margin/ EBIT.